Combined ratios are the standard gauge of performance in the insurance industry. Yet the combined ratio relates only to underwriting profit and neglects income generated from the investment of premiums. Obviously short-tail insurers tend to have the most desirable combined ratios. If they don’t hold premiums long enough to make adequate investment income, they had better make an underwriting profit. It’s also obvious that a long-tail insurer, by having plenty of time to invest premiums, can compensate for mediocre underwriting with superior investment returns. In his 1996 annual letter, Warren Buffett cogitates over this point and proposes a useful gauge of performance:

Measuring Insurance Performance

In the previous section I mentioned “float,” the funds of others that insurers, in the conduct of their business, temporarily hold. Because these funds are available to be invested, the typical property-casualty insurer can absorb losses and expenses that exceed premiums by 7% to 11% and still be able to break even on its business. Again, this calculation excludes the earnings the insurer realizes on net worth - that is, on the funds provided by shareholders.

However, many exceptions to this 7% to 11% range exist. For example, insurance covering losses to crops from hail damage produces virtually no float at all. Premiums on this kind of business are paid to the insurer just prior to the time hailstorms are a threat, and if a farmer sustains a loss he will be paid almost immediately. Thus, a combined ratio of 100 for crop hail insurance produces no profit for the insurer.

At the other extreme, malpractice insurance covering the potential liabilities of doctors, lawyers and accountants produces a very high amount of float compared to annual premium volume. The float materializes because claims are often brought long after the alleged wrongdoing takes place and because their payment may be still further delayed by lengthy litigation. The industry calls malpractice and certain other kinds of liability insurance “long- tail” business, in recognition of the extended period during which insurers get to hold large sums that in the end will go to claimants and their lawyers (and to the insurer’s lawyers as well).

In long-tail situations a combined ratio of 115 (or even more) can prove profitable, since earnings produced by the float will exceed the 15% by which claims and expenses overrun premiums. The catch, though, is that “long-tail” means exactly that: Liability business written in a given year and presumed at first to have produced a combined ratio of 115 may eventually smack the insurer with 200, 300 or worse when the years have rolled by and all claims have finally been settled.

The pitfalls of this business mandate an operating principle that too often is ignored: Though certain long-tail lines may prove profitable at combined ratios of 110 or 115, insurers will invariably find it unprofitable to price using those ratios as targets. Instead, prices must provide a healthy margin of safety against the societal trends that are forever springing expensive surprises on the insurance industry. Setting a target of 100 can itself result in heavy losses; aiming for 110 - 115 is business suicide.

All of that said, what should the measure of an insurer’s profitability be? Analysts and managers customarily look to the combined ratio - and it’s true that this yardstick usually is a good indicator of where a company ranks in profitability. We believe a better measure, however, to be a comparison of underwriting loss to float developed.

This loss/float ratio, like any statistic used in evaluating insurance results, is meaningless over short time periods: Quarterly underwriting figures and even annual ones are too heavily based on estimates to be much good. But when the ratio takes in a period of years, it gives a rough indication of the cost of funds generated by insurance operations. A low cost of funds signifies a good business; a high cost translates into a poor business.

On the next page we show the underwriting loss, if any, of our insurance group in each year since we entered the business and relate that bottom line to the average float we have held during the year. From this data we have computed a “cost of funds developed from insurance.”

                  (1)            (2)                           Yearend Yield

              Underwriting                     Approximate      on Long-Term

                  Loss       Average Float    Cost of Funds     Govt. Bonds

              ------------   -------------   ---------------   -------------

                    (In $ Millions)         (Ratio of 1 to 2)

1967 .........   profit           $17.3       less than zero       5.50%

1968 .........   profit            19.9       less than zero       5.90%

1969 .........   profit            23.4       less than zero       6.79%

1970 .........    $0.37            32.4                1.14%       6.25%

1971 .........   profit            52.5       less than zero       5.81%

1972 .........   profit            69.5       less than zero       5.82%

1973 .........   profit            73.3       less than zero       7.27%

1974 .........     7.36            79.1                9.30%       8.13%

1975 .........    11.35            87.6               12.96%       8.03%

1976 .........   profit           102.6       less than zero       7.30%

1977 .........   profit           139.0       less than zero       7.97%

1978 .........   profit           190.4       less than zero       8.93%

1979 .........   profit           227.3       less than zero      10.08%

1980 .........   profit           237.0       less than zero      11.94%

1981 .........   profit           228.4       less than zero      13.61%

1982 .........    21.56           220.6                9.77%      10.64%

1983 .........    33.87           231.3               14.64%      11.84%

1984 .........    48.06           253.2               18.98%      11.58%

1985 .........    44.23           390.2               11.34%       9.34%

1986 .........    55.84           797.5                7.00%       7.60%

1987 .........    55.43         1,266.7                4.38%       8.95%

1988 .........    11.08         1,497.7                0.74%       9.00%

1989 .........    24.40         1,541.3                1.58%       7.97%

1990 .........    26.65         1,637.3                1.63%       8.24%

The float figures are derived from the total of loss reserves, loss adjustment expense reserves and unearned premium reserves minus agents’ balances, prepaid acquisition costs and deferred charges applicable to assumed reinsurance. At some insurers other items should enter into the calculation, but in our case these are unimportant and have been ignored.

During 1990 we held about $1.6 billion of float slated eventually to find its way into the hands of others. The underwriting loss we sustained during the year was $27 million and thus our insurance operation produced funds for us at a cost of about 1.6%. As the table shows, we managed in some years to underwrite at a profit and in those instances our cost of funds was less than zero. In other years, such as 1984, we paid a very high price for float. In 19 years out of the 24 we have been in insurance, though, we have developed funds at a cost below that paid by the government.

There are two important qualifications to this calculation. First, the fat lady has yet to gargle, let alone sing, and we won’t know our true 1967 - 1990 cost of funds until all losses from this period have been settled many decades from now. Second, the value of the float to shareholders is somewhat undercut by the fact that they must put up their own funds to support the insurance operation and are subject to double taxation on the investment income these funds earn. Direct investments would be more tax-efficient.

The tax penalty that indirect investments impose on shareholders is in fact substantial. Though the calculation is necessarily imprecise, I would estimate that the owners of the average insurance company would find the tax penalty adds about one percentage point to their cost of float. I also think that approximates the correct figure for Berkshire.

Figuring a cost of funds for an insurance business allows anyone analyzing it to determine whether the operation has a positive or negative value for shareholders. If this cost (including the tax penalty) is higher than that applying to alternative sources of funds, the value is negative. If the cost is lower, the value is positive - and if the cost is significantly lower, the insurance business qualifies as a very valuable asset.

So far Berkshire has fallen into the significantly-lower camp. Even more dramatic are the numbers at GEICO, in which our ownership interest is now 48% and which customarily operates at an underwriting profit. GEICO’s growth has generated an ever-larger amount of funds for investment that have an effective cost of considerably less than zero. Essentially, GEICO’s policyholders, in aggregate, pay the company interest on the float rather than the other way around. (But handsome is as handsome does: GEICO’s unusual profitability results from its extraordinary operating efficiency and its careful classification of risks, a package that in turn allows rock-bottom prices for policyholders.)

Many well-known insurance companies, on the other hand, incur an underwriting loss/float cost that, combined with the tax penalty, produces negative results for owners. In addition, these companies, like all others in the industry, are vulnerable to catastrophe losses that could exceed their reinsurance protection and take their cost of float right off the chart. Unless these companies can materially improve their underwriting performance - and history indicates that is an almost impossible task - their shareholders will experience results similar to those borne by the owners of a bank that pays a higher rate of interest on deposits than it receives on loans.

All in all, the insurance business has treated us very well. We have expanded our float at a cost that on the average is reasonable, and we have further prospered because we have earned good returns on these low-cost funds. Our shareholders, true, have incurred extra taxes, but they have been more than compensated for this cost (so far) by the benefits produced by the float.

A particularly encouraging point about our record is that it was achieved despite some colossal mistakes made by your Chairman prior to Mike Goldberg’s arrival. Insurance offers a host of opportunities for error, and when opportunity knocked, too often I answered. Many years later, the bills keep arriving for these mistakes: In the insurance business, there is no statute of limitations on stupidity.

The intrinsic value of our insurance business will always be far more difficult to calculate than the value of, say, our candy or newspaper companies. By any measure, however, the business is worth far more than its carrying value. Furthermore, despite the problems this operation periodically hands us, it is the one - among all the fine businesses we own - that has the greatest potential.